Exchange Traded Funds as Market Predictors

The fact that exchange traded funds (ETFs) reflect the market is generally well-known and understood. These funds are tied to the index to which they belong and as a result paint a clear picture of market conditions. But is it possible ETFs could also have a determinant role to play in those conditions?

WSJ.com’s MarketBeat thinks so, particularly when ETF volumes exceed those of individual stocks. “Investors turn more to ETFs as a hedge when they can’t count on fundamental stock-picking to generate good results,” MarketBeat reports. In an economy that’s still in the process of recovery, investors try to avoid big losses even more than they seek out large gains. The fact that the volume of ETFs now exceeds that of individual stocks seems to bear this out.

According to Liz Myers of J.P. Morgan Chase, “A long-only equity investor’s mandate is to find returns investing in single stocks. In a market with correlations as high as they are, it becomes more challenging to pick the winners.” The MarketBeat report goes on to say that bankers and investment professionals on Wall Street view ETFs as indicators of investor mood. The relatively volatile state of the current market means that stock correlation is at an all-time high. As a result, choosing winning and losing stocks becomes a much more difficult proposition. As market strategist Steve Wood says, “”When correlation goes up, the differences within a sector or even between industries drop, and all things are evaluated as being the same.”

It’s not just investor sentiment that can be read by following ETFs; they can be used to assess the mood of financial advisors as well. According to Investors Intelligence, their mood is on the rise:

“There were fewer bears in the latest week at 32.6% from 34.7% a week ago and 46.3% to start October. That was the most bears since March 2009 when they peaked at 47.2%. That high reading signaled that the advisors were raising cash and contrarians recognized it as a buying opportunity.” (Investors Intelligence, Nov. 16, 2011)

Market analysts attribute the popularity of ETFs–and the rise in investor confidence this reflects–to several well-known characteristics of the investment alternative. ETFs provide a more predictable income stream than do individual stocks or mutual funds. The passive management of ETFs lowers the overall tax bite to the investor. They are structured in a particularly transparent fashion; active-managed mutual funds can seem almost opaque by comparison. They also incur higher management fees; some funds that outperform ETFs may actually lose money in the long run. For some private investors for whom predictability of income flow is of paramount importance, ETFs are the clear choice.